Carry Trade Is Back, but With New Risks

The carry trade is making a comeback, but in a new form and with new risks.

The old carry trade was a relatively predictable creature. It meant borrowing funds in low-interest rate currencies like the Japanese yen, and depositing them into stable high yielders like the Australian dollar — for easy returns.

Now, investors looking to profit from differences in interest rates have to turn to the Indonesian rupiah, the Brazilian real, or even the Russian ruble to generate results — far riskier propositions.

Critical to the strategy’s success was the notion that currencies like the yen and Australian dollar would trade in relatively foreseeable ways. The Aussie’s steady gains against the yen in 2006 and the first half of 2007 only added to profits from interest rate spreads.

Fast-forward to 2009 and funding currencies like the yen and the dollar are cheaper than ever. Interest rates in both countries are close to zero, with their central banks seemingly intent on printing money to escape recession.

Investors with funds in hand have plenty of places to park their money, with rates ranging from 7.5% in Indonesia, to 13% in Russia. Fear, meanwhile, is receding: Stocks are up, emerging market currencies are ticking higher, while bond offerings in the developing world are being snapped up.

Much of the carry trade’s success in its heyday rested on the enormous leverage that investors could deploy to magnify their returns. Leverage now, of course, is the dirtiest word in the financial lexicon.

And while the new carry trade may be less leveraged, it’s an inherently riskier bet. As such, it’s more vulnerable to the kind of swift unraveling of risk appetite observed across all nations and sectors in 2008, but which occurs with far more frequency in emerging markets.

Investors turning directly to the Indonesian rupiah have driven the currency nearly 12% higher against the dollar in the past month, and been rewarded by an event-free national election that will only bolster investment flows.

In terms of beating the consensus forecast, J.P. Morgan’s 25% margin doesn’t compare with Goldman’s home run. But in other ways, its results look better. J.P. Morgan’s big win came in fixed-income markets. Unlike Goldman, this didn’t come with a big jump in the bank’s overall value-at-risk measure, although in absolute dollars it remains higher. Nor did the skew toward trading revenue look as pronounced, with J.P. Morgan’s equity underwriting and advisory businesses showing more resilience.

Both banks’ results may reflect the emergence of industry haves and have-nots. Most banks rely on Washington’s helping hand right now. Cheap government-guaranteed financing most likely helped institutions take trading risks they might otherwise have curtailed.

But the likes of J.P. Morgan are setting themselves apart. Even without TARP, J.P. Morgan says its Tier 1 capital ratio is above its target range of 8% to 8.5%.

J.P. Morgan’s Achilles’ heel is exposure to consumers, where guidance on losses accelerated in credit cards, home-equity loans and prime mortgages. At least, however, the bank can funnel investment-banking profits into loan-loss reserves.

With unemployment still rising and home prices still falling, those banks less able to take risk likely will struggle. That is bad for them, but no picnic for regulators trying for broad resuscitation, either.